A former portfolio manager’s conviction for insider trading was upheld by a federal appeals court, which in so ruling, admittedly stepped back from the reasoning of one of its recent decisions. Also, an investment adviser agreed to pay total sanctions of approximately US $5 million to settle an enforcement action by the Securities and Exchange Commission for allegedly failing to have and follow policies and procedures reasonably designed to prevent insider trading. Separately, ICE Futures U.S. settled another anti-spoofing disciplinary action against a trader who, on multiple occasions, purportedly placed only a single large order on one side of the market to induce the execution of a smaller order on the other side. The trader apparently did not utilize layered orders to facilitate his fills as has been more customary in spoofing cases. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Last week, a three-judge panel of the federal appeals court in New York upheld the September 2014 conviction of Mathew Martoma, a former portfolio manager for S.A.C. Capital Advisors, LLC – then a hedge fund – for insider trading.

The court held by a 2-1 vote that, contrary to guidance in a 2014 decision it also issued, a corporate insider who has a fiduciary duty not to disclose any material, nonpublic information of his company (“tipper”) and a non-insider who receives material, nonpublic information (“tippee”) are not required to have a “meaningfully close personal relationship” to infer the tipper’s receipt of a personal benefit for a gift of proprietary information to the tippee.

Mr. Martoma was found guilty of insider trading and later sentenced to nine years imprisonment in 2014 as a result of his role in the trading of the securities of two pharmaceutical companies by SAC Capital following his receipt of alleged insider information from at least one paid consultant regarding the efficacy of an experimental drug the companies were developing to treat Alzheimer's.

According to a 1983 decision by the US Supreme Court, the receipt of a personal benefit is a requisite to finding that a tipper breached his/her fiduciary duty to his/her company. Only if a tippee knew or should have known that the tipper was breaching his/her fiduciary relationship to his/her company, can a tippee potentially be convicted for insider trading. (Click here to access the Supreme Court’s decision in Dirks v. SEC.) Previously, the Supreme Court ruled that, absent a breach of a fiduciary duty, there is generally no prohibition for market participants from trading on material, non-public information. (Click here to access the Supreme Court’s decision in Chiarella v. United States.)

In some cases, said the Supreme Court in its 1983 decision, the relationship between a tipper and tippee suggests a “quid pro quo” or an intention to benefit the tippee. In other circumstances, however, where an insider provides a gift of confidential information to a relative or friend who then trades on it, “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

In this case involving Mr. Martoma, the federal appeals court held that “a corporate insider personally benefits whenever he ‘discloses information as a gift …with the expectation that [the recipient] would trade’ on the basis of such information …because such a disclosure is the functional equivalent of trading on the information himself and giving a cash gift to the recipient.” (Emphasis added.) There does not need to be a “meaningfully close relationship” between a tipper and tippee for prohibited insider trading to occur, explained the court.

The federal appeals court hearing Mr. Martoma’s appeal had ruled differently in a 2014 decision reversing the insider-trader conviction of Todd Newman and Anthony Chiasson – former portfolio managers – for insider trading. There the court held that, in its prosecution of the defendants, the US government failed to demonstrate that the initial insiders from whom defendants’ liability ultimately derived received sufficient personal benefit to establish their (let alone defendants’) securities law liability. In part, this was because there was no meaningfully close relationship between the tipper and tippee. (Click here for background on this decision in the article “Appeals Court Sets Aside Insider Trading Convictions Saying Traders Distance From Corporate Insiders Too Far” in the December 14, 2014 edition of Bridging the Week.)

Subsequent to the Newman decision, however, the US Supreme Court reiterated its earlier 1983 pronouncement that, “the giving of a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds” to a tippee whenever a corporate insider gives confidential information with the expectation that the recipient will trade based on it. This was done in a decision upholding the insider-trading conviction of Bassam Salman, an individual trader. (Click here for background on this decision in the article “Supreme Court Rules Sharing of Nonpublic Information With Relative Is Sufficient to Find Illegal Insider Trading in Tipper/Tippee Context” in the December 11, 2016 edition of Bridging the Week.) The federal appeals court acknowledged in upholding Mr. Martoma’s conviction that it was revising its views expressed in Newman relying on the “logic” of the Supreme Court’s decision in Salman.

Although the federal appeals court in Martoma determined to follow Salman, it noted that it did not have to in order to uphold Mr. Martoma’s conviction. This was because, in this case, the tipper that provided Mr. Martoma with confidential insight regarding the experimental Alzheimer's drug received “substantial financial benefit” for providing nonpublic information – concretely evidencing his breach of fiduciary duty. Specifically, the court observed that for 18 months, the alleged tipper – the paid consultant – billed Mr. Martoma US $1,000/hour for 43 hours of consultation sessions.

One judge – the Hon. Rosemary Pooler – dissented from the court’s majority opinion, claiming that if someone who gives a gift of inside information is deemed always to have received a personal benefit there may be no limitation on who may ultimately be prosecuted as a potential tippee. “[T]here is great wisdom in the Supreme Court’s limitations on broad rules, particularly when those rules might otherwise allow punishment of the absentminded in addition to persons with corrupt intentions,” wrote Ms. Pooler.

Legal Weeds: The provisions of applicable law and SEC rule that serve as the basis for a civil action or criminal prosecution for insider trading of securities are the inspiration for similar provisions of law and a rule of the Commodity Futures Trading Commission that prohibit employment of a manipulative or deceptive device or contrivance in connection with futures and swaps trading. (Click here to access the relevant securities law, 15 USC § 78j(b) and here to access SEC Regulation 10b-5, 17 CFR §240.10b-5. Click here to access 7 US Code § 9(1), and here to access CFTC Rule 180.1.) The CFTC has brought two actions that sound in the securities law concept of insider trading for an employee impermissibly trading based on futures positions of his employer. (Click here for background on both cases in the article “Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information” in the October 2, 2016 edition of Bridging the Week.) The CFTC has not brought the equivalent of an insider trading enforcement action against anyone other than a person who, as an employee, directly was alleged to have misappropriated the nonpublic, confidential information of his employer.

Briefly:

Investment Adviser Agrees to Pay Almost US $5 Million to Resolve SEC Charges of Not Having Adequate Insider Trading Prevention Policies and Procedures: Deerfield Management Company, L.P., agreed to pay a fine of US $3.946 million to the Securities and Exchange Commission to resolve charges that, from 2012 through 2014, it failed to have and enforce policies and procedures reasonably designed to prevent the misuse of material, nonpublic information.

According to the SEC, during this time, the firm, an SEC-registered investment adviser, did not have policies and procedures that addressed the risk that its employees could use material, nonpublic information illicitly obtained from its research firms, particularly those specializing in political intelligence.

Previously, criminal charges were filed against five persons, including three Deerfield partners and analysts, for allegedly dealing in confidential proprietary information first obtained from a government official, passed along to a consultant, and then passed along to the three Deerfield partners who used the political intelligence to fashion trades for Deerfield-managed hedge funds. (Click here for background on the prior criminal and SEC action related to this matter in the article “Alleged Conduit to Hedge Fund for Confidential Non-Public Government Information Criminally Charged for Insider Trading Along with Three Fund Partners and Government Employee” in the June 4, 2017 edition of Bridging the Week.)

The SEC claimed that, although Deerfield had policies and procedures addressing information received from expert consultants, it did not have equivalent policies and procedures addressing information received from research firms. Research firms, said the SEC, were “required only to demonstrate that they ‘observe policies and procedures to prevent the disclosure of material non-public information or any information in breach of a duty'.” However, even this policy was not followed by Deerfield for all research firms, claimed the SEC.

Additionally, the SEC claimed that, during the relevant time, Deerfield did not act on red flags that it was potentially receiving information regarding confidential government decisions before public announcement.

To resolve this matter with the SEC, Deerfield agreed to disgorge profits of over US $800,000, including interest, in addition to paying a fine.

Again, ICE Futures U.S. Charges Spoofing Based on Single Large Orders on One Side of Market: For the second week in a row, ICE Futures U.S. settled a disciplinary action based on allegations of spoofing, where the alleged wrongful conduct purportedly constituted placing single large orders on one side of a market to influence the execution of single smaller orders on the other side of the market. In the most recent matter, Trevor Stanley agreed to pay a fine of US $30,000 and to serve a 120-day trading suspension on all IFUS markets to resolve charges that, from April 2016 to July 2016, he engaged in a “pattern of trading activity” involving the placement of a single large order involving the Russell 2000 Index Mini futures contract on one side of the market, and a small order on the opposite side. According to IFUS, Mr. Stanley would cancel the large order shortly after the small order was executed. IFUS claimed that Mr. Stanley’s trading activity caused “order book imbalances” prompting the execution of his smaller orders.

Two weeks ago, Dominick Minervini, a former floor broker registered with the Commodity Futures Trading Commission, agreed to pay a fine of US $200,000 to IFUS to resolve similar charges that he may have engaged in impermissible spoofing-type activity involving Sugar No. 11 futures contracts. According to IFUS, Mr. Minervini, on numerous occasions, created “order book imbalances” by entering a small order to buy or sell on one side of the market, and a large order to sell or buy on the other side of the market. The exchange claimed that on “numerous instances” Mr. Minervini would also cancel the large order after the small order was executed. (Click here for background regarding Mr. Minervini’s settlement in the article “Former Floor Broker Agrees to US $200,000 Fine to Resolve ICE Futures U.S. Spoofing Allegations” in the August 20, 2017 edition of Bridging the Week.)

Compliance Weeds: Although the overwhelming majority of reported spoofing cases brought to date by the CFTC and exchanges have involved layering of multiple orders on one side of a market against a single smaller order on the other side, it is possible that, under certain market conditions, a single large order could artificially drive the market in a particular direction. The two recent IFUS enforcement actions suggest that trading firms monitoring for potential spoofing activity might wish to consider refining their surveillance to try to capture this additional type of conduct (e.g., a small order placed on one side of the market is followed by placement of a large order on the other side of the market moving the market in a direction causing the small order to be executed. Afterwards the large order is immediately cancelled).

Canadian Securities Regulators Issue Guidance on Digital Token Offerings: The Canadian Securities Administrators published guidance regarding how securities and derivatives laws in Canada might be impacted by initial coin offerings and the sales of investment funds consisting of digital tokens. Generally, according to CSA, Canadian law requires (1) the use of approved disclosure documents prior to a sale of securities, unless the sale is conducted pursuant to a private placement in reliance on a prospectus exemption; (2) the registration of businesses and persons involved in the trading or advising of securities, unless there is an exemption; and (3) the compliance with marketplace requirements for platforms that trade securities, unless there is an exemption.

In its summary, the CSA noted that, to date, no digital token exchange has been recognized as an exchange in any Canadian jurisdiction or exempted from registration.

As in the US, token sales associated with an ICO may be considered a security in Canada, said the CSA, if it involves an investment of money in a common enterprise with the expectation of profit arising significantly through the efforts of others. Prospectus exemptions may be available for sophisticated investors known as “accredited investors.”

CSA indicated that businesses undertaking ICOs may be trading in securities for a business purpose and thus require registration unless there is an exemption. CSA stated that determinations of whether trading is for a business purpose include whether the business is soliciting a broad group of investors, including retail persons; using the internet to reach a broad group; attending public conferences and advertising to solicit a broad group; and raising a large amount of funds from a broad group.

Legal Weeds: The CSA advisory makes clear that regulator issues related to the offer and trading of digital tokens is not solely a US phenomenon. On July 25, the Securities and Exchange Commission published a Report of Investigation that concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement. (Click here for background on the SEC’s Report of Investigation in the article “SEC Warns that Digital Tokens May Be Securitas” in an August 3, 2017 Advisory by Katten Muchin Rosenman LLP.)

One More Time – CME Group Resubmits Direct Funding Participant Proposal to CFTC: CME Group, for the second time, submitted amendments to its proposed rule changes previously provided to the Commodity Futures Trading Commission in July 2016 authorizing a new category of clearing membership, termed a “Direct Funding Participant.” Under CME Group’s proposal, a DFP could clear all of its own CME Group trades directly with the CME clearinghouse but would not be obligated to contribute to CME Group’s guaranty fund or otherwise be responsible in case of a default by another clearing member. Instead, all of a DFP’s obligations (except for obligations arising from disciplinary actions against a DFP) to CME Group would be guaranteed by at least one other CME Group clearing member – termed a “DFP Guarantor” – that was registered with the CFTC as a futures commission merchant. DFPs would respond to all collateral calls by paying the CME clearinghouse directly, but their performance bond requirements would typically be 104 percent of ordinary amounts. Among other things, CME Group’s latest amendments address clarifications of certain information requested by the Futures Industry Association and membership requirements for DFPs. CME Group anticipates its new rules being effective by no later than October 25. (Click here for background on CME Group’s DFP proposal in the article “CME Group Revises July 2016 Proposal Authorizing End Customers to Become Direct Clearing Members Without Incurring Liability for Default of Other Members” in the April 23, 2017 edition of Bridging the Week.)

Helpful to Getting the Business Done: Prior to CME Group’s initially proposed DFP model, EUREX rolled out its own version of a direct clearing membership called ISA Direct. A big difference between CME Group’s DFP model and ISA Direct is that under ISA Direct a clearing member does not guarantee its client’s performance. However, ISA Direct participation is limited to eligible insurance companies, financial institutions, pension funds and investment funds domiciled in the European Union or Switzerland. (Click here for details regarding ISA Direct in the article “Before There Was CME Group’s Direct Funding Participant Clearing Membership Proposal There Was Eurex’s ISA Direct” in the August 7, 2016 edition of Bridging the Week.) ICE Clear Europe also maintains a program similar to the DFP model known as “Individual Segregation through Sponsored Principal Account.” Under ICE Clear’s Europe’s model, clients of clearing members may elect to become a direct counterparty of the clearinghouse in connection with their transactions. Under this arrangement, a client, known as the “sponsored principal,” maintains a separate account at ICE Clear Europe, as joint tenant with its clearing member broker, known as the “sponsor,” and is jointly liable with its sponsor for all positions in such account. (Click here for background on ICE Clear’s ISSPA model in the article “…And Don’t Forget ICE Clear Europe’s Individual Segregation Through Sponsored Principal Account Offering” in the August 21, 2016 edition of Bridging the Week.)

Federal Reserve Chair Argues Financial System Stronger Because of Post-Financial Crisis Reforms; Recommends No More Than Modest Changes: In a speech last week, Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, argued that reforms instituted in the United States and world-wide following the 2007-2008 financial crisis have made the financial system “substantially safer.” Generally, she claimed, large banks have reduced by half their reliance on short-term wholesale funding and hold more high-quality, liquid assets; prime institutional money markets funds that “proved susceptible to runs in the crisis” now hold significantly less assets; and regulators have better capability to resolve a large financial institution in dire stress. Ms. Yellen discounted claims that financial reforms have inhibited lending, saying that “…adverse effects of capital regulation on broad measures of lending are not readily apparent.” Notwithstanding, Ms. Yellen noted there might be “benefits” to simplify unspecified parts of the Volcker Rule that limited proprietary trading by banking firms, and to review the interaction of certain bank capital rules. However, concluded Ms. Yellen, “any adjustments to the regulatory framework should be modest and preserve the increase in resilience at large dealers and banks associated with the reforms put in place in recent years.”

Policy and Politics: Currently, the Office of the Comptroller of the Currency is seeking comments on how the specific requirements it adopted to implement the Volcker Rule should be amended to better effectuate the purposes of the statute. (Click here for background in the article, “OCC Seeks Input How Volcker Regulations Should Be Amended” in the April 6, 2017 edition of Bridging the Week.) Approximately two months ago, the US Department of Treasury of a report calling for substantial amendments to the Volcker Rule and containing other recommendations regarding the regulation of banks and credit unions, in response to President Donald Trump’s Core Principles for the federal regulation of the US financial system issued earlier this year. (Click here for background on Treasury’s recommendations as well as the Core Principles in the article “US Department of Treasury Recommends Modifications to Volcker and Bank Capital Rules, and Rationalization of Financial Regulation” in the June 18, 2017 edition of Bridging the Week.) Clearly there is not unanimity in Washington, DC among policy-makers regarding the impact of post-financial crisis reforms, including all aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Ms. Yellen's current term as FRB chair expires February 3, 2018.

More briefly:

Convicted Trader Says He Did Not Spoof Under Federal Appeals Court Test Upholding His Conviction: Last week, Michael Coscia, the first person convicted under the anti-spoofing provision of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, petitioned the US federal appeals court that recently upheld his conviction and sentencing for a re-hearing. Mr. Coscia claimed that the three-judge panel that upheld his conviction misapplied its “own newly-articulated test” for distinguishing lawful and unlawful trading — mainly that “legal trades are cancelled only following a condition subsequent to placing the order, whereas orders placed in a spoofing scheme are never intended to be filled at all.” Mr. Coscia claimed that since all his allegedly layered orders were cancelled following conditions subsequent to his order placement, the panel’s application of its new rule to him jeopardizes the trading by all traders who might place conditional orders of any kind, including fill-or-kill or stop-limit orders. Mr. Coscia seeks a re-hearing before all the judges of the federal appeals court that sits in Chicago. (Click here for background on the federal appeals court’s ruling in Coscia in the article “Federal Appeals Court Upholds Conviction and Sentencing of First Person Criminally Charged for Spoofing Under Dodd-Frank Prohibition” in the August 7, 2017 edition of Between Bridges.)

Two Former Bank Managers Criminally Charged With Instructing Subordinates to Submit Misleading LIBOR Information: Danielle Sindzingre and Muriel Bescond, managers at Société Générale, S.A., based in Europe, were indicted last week for allegedly instructing subordinate employees to submit inaccurate information related to the London Interbank Offered Rate to daily contributions that were utilized to calculate the benchmark rate. The US Department of Justice, responsible for filing the indictment, alleged that the submitted information reflected lower rates than the rates at which the bank was actually borrowing money. On “numerous occasions” these submissions impacted the published LIBOR calculation, impacting financial transactions based on LIBOR on the relevant days, the DoJ alleged. The indictment was filed by the DoJ in a federal court in Brooklyn, NY. At this point, the indictment solely represents unproved allegations.

FINRA Requires No Fine Where Broker-Dealer Members Provided “Extraordinary Cooperation” After Allegedly Overcharging Fees to Certain Customers: A number of broker-dealers were assessed censures but no fines in settlements with the Financial Industry Regulatory Authority related to their offer and sale of shares of mutual funds to certain retirement plans and charitable organization customers with front-end sales charges when they were eligible to purchase shares without such charges. FINRA said each of the firms evidenced “extraordinary cooperation” by having initiated an internal investigation prior to being contacted by a regulator; establishing a plan of remediation; self-reporting; taking remedial steps; and implementing corrective steps “prior to detection or intervention by a regulator.”

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of August 26, 2017. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

Archives

ABOUT GARY DEWAAL

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.